Food For Thought

We are all feeling the pinch of higher prices, and are used to increases in gasoline, health care and homes. No one likes it, but we’ve come expect it. When it comes to groceries, however, and milk surging to $4.85 per gallon, look out. Kevin Kerr explains…

As an American man in my early 40s, I can say that for most of my life, I have taken certain things for granted. I don’t mean that I have been ungrateful for the abundance this country has to offer. I would say, instead, that I’ve been oblivious.

Now don’t get me wrong – as a child and young adult, I was fortunate enough to travel all over the world. My father made it a point to take us everywhere, and we often saw countries where there was poverty and no such things as running water, 7-Elevens or mega-malls, and where there were certainly no Starbucks, health care or gigantic well-stocked supermarkets. No, I was aware we had much more of everything in the U.S. – clearly, we had it better here. But as a child, I just never thought it could change.

Then I grew up.

When I was a kid, I would spend a lot of time at my grandparents’ house on Sundays while my parents went to the Minnesota Vikings games – they were big fans. (Trust me, you had to be a big fan in those days – the stadium was outside, and it was darn cold in January. That was when NFL football was good.)

Anyway, my grandmother was in her 70s and had lived through the Great Depression and a couple of world wars, so she had seen hard times indeed. In her basement, she had a room that was filled from top to bottom with canned foods from her garden. It was an enormous garden filled with produce, not flowers. (Well, maybe a few flowers.) She also had a gigantic bin filled with coffee, and an even bigger industrial garbage can from Sears, filled with sugar. As a kid, I remember asking her why she had all that sugar in the garbage can. She replied, "Because you never know, Kevie." I had no idea what she meant. Now all I can think is how right she was.

Who knows, maybe she planted the seed right then and there for me to be interested in commodities trading? Heck, I would give a lot for Grandma’s sugar-filled garbage can today, with sugar prices surging the way they have at the start of 2008.

As I have said for the last three years, the soft commodities are much undervalued, and we are seeing that move now just as we did in grains, and as we did in energies before that. The move higher in soft commodities like coffee, cocoa, sugar, cotton and others is just starting, not ending.

I really enjoy history. I can’t say I am a scholar of history – I’m more like a History Channel buff. It’s interesting that when we look at the history of food prices in America, we see that in 1901, people spent 43% – almost half – of their income on food, according to the Bureau of Labor Statistics. Do you know what that figure was in 2003? We will answer that in a minute.

It is true that since 1901, the percentage of our income spent on food has dropped dramatically, and it would seem to confirm a theory called Engel’s Law. Engel’s Law is the observation by 19th century German statistician Ernst Engel that "The proportion of income spent on food falls as income rises." But look deeper. Has spending gone down, or has it just shifted elsewhere?

Upon closer examination of my own spending, I realize that as I get older, my rising income has also meant more dining out. Restaurant dining and takeout food require even more energy, and are more expensive. Look at your own history, and you will see what I mean.

The extra money has certainly not gone into savings accounts, since the U.S. has one of the worst savings rates in the world, as well as some of the highest credit debt. According to the Bureau of Labor Statistics, the average American family spent $40,817 on goods and services in 2003. So where did all that money go?

OK, now the answer to our question. How much did the average family spend on food in 2003? Only about 14%, or a vast improvement over 1901, right?

Well, not really.

According to Advertising Age magazine, "Unlike in 1901, in 2003, the majority of the family budget went for the house (33 cents of every dollar) and car (19 cents). After paying for food (13 cents), medical bills (6 cents), a little booze (1 cent) and more, families had a nickel left to spend on entertainment." A nickel?

I just went to a Florida amusement park with my wife and baby, and at $200 for entry – trust me – a nickel is a little bit of an understatement.

And I will also say that in the area where I live in Connecticut, I see people living in these vast McMansions that cost $1-3 million. And they earn less than I do. I am just astonished. They must be spending 70%-plus of their incomes on their mortgages.

There is absolutely no doubt that consumer spending has increased exponentially since 1950. OK, let the good times roll. The government and die-hard bulls immediately point out that factoring in inflation, the increase is less dire. Maybe, but the "adjusted for inflation argument" won’t feed your family or run your car. Try paying your mortgage and telling the bank that adjusted for inflation, your payment should be 30% less. See if they foreclose on only 30% of your house.

So we are all feeling the pinch of higher prices. We are used to increases in gasoline, health care and homes. We don’t like it and we complain, but we expect it and we continue to fill up our Hummer and grumble and drive on. When it comes to groceries, however, and milk surging to $4.85 per gallon, look out.

How is this possible? How could it have happened? Ah, you can almost hear Marlon Brando saying, "The horror!"

My daughter turned 1 year-old in January. We always have to remind her not to play with her food. You would expect to have to do that with a 1-year-old. But you wouldn’t expect to have to do that with our government leaders. (But come to think of it, many of them could use a good spanking.)

I am often asked by private clients, TV and radio interviewers, readers like yourself and others, "Why is this happening? Why are food prices surging?"

Simple. Stupidity, I think to myself.

The United States has some of the richest farmland in the world and more modern farming equipment than any other nation on Earth. The problem is we also use a lot of energy, and that is one thing we don’t have much of. So what are we to do?

Then the political light bulb came on – dimly, but it came on. The idea was to turn a key staple of our food supply (corn) into fuel and thus create a panacea for the energy problem. This was a miracle, right? Wrong. Ethanol is nothing new; it has been around since cars first rolled out of Detroit. Ethanol from corn comes at a very high price. Not only does it require several steps to turn corn into ethanol, but it requires acres more of land, fertilizer, fuel, water, etc. At the end of the day, the only thing that widespread ethanol use is doing is destroying more of our natural resources while perpetuating the myth that we are doing something about our energy problem. It’s almost criminal.

Now, don’t get me wrong. Farmers have used ethanol for years locally, and in many instances, it makes complete sense. After all, growing a limited amount of corn on your own farm and refining it a few miles away at the co-op ethanol plant and then running your farm equipment and also pocketing a little coin at the same time – while providing some ethanol to the local community – made sense. Unfortunately, the government, lobbyists and politicians have perverted ethanol into a national mandate and thrown billions in subsidies to the industry.

It has become so absurd that farmers are becoming careless, throwing aside less-profitable crops like cotton and wheat.

In addition, being overlooked are prudent farming methods like crop rotation and not growing corn on corn, or the process of growing a different crop the year after you grow corn in a particular field. The environmental statistics are staggering, too.

In Wisconsin, for example, local rivers and tributaries have been dropping rapidly due to all of the extra water consumption – millions and millions of gallons. One local farmer in my farmers network says that he has lived in one location for 60 years and has never seen the lake near his farm so low. He says the local ethanol plant is talking about having water "shipped in." You have got to be kidding!

So what does all of this mean for us as investors? Plenty!

The days of cheap oil are already with us, and by adding certain key energy stocks to the OI portfolio, we, in essence, have a hedge against higher oil prices. We need to consider doing the same for food in our portfolio. I will tell you that in my own portfolios, I do have exposure to soybeans, wheat, corn and all the soft commodities. And they have done very well for me – as well as for our Resource Trader Alert members. In addition, stocks that will continue to benefit from rising food costs and global demand are companies like John Deere, Caterpillar, Monsanto, DuPont and The Andersons.

There is no doubt in my mind that oil prices will continue to go much higher, however. Eventually, when they get too high (that may be when oil is $600 per barrel), we may finally have a car that runs on switch grass, but clearly, this will not happen anytime soon. The difference between food and fuel is there is never going to be an alternative for food. We all need to eat, and there is no substitute. Did you ever chew on a piece of switch grass? I rest my case. The time to protect your portfolio from rising food costs is now. The days of cheap food are over.

Regards,

Kevin Kerrfor The Daily Reckoning
March 20, 2008

Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

Yesterday, the world had a chance to take a better look at the Fed’s latest rate cut…

"Yecch," it said. And so "Hell Week" continued.

Despite the Fed’s intervention, in both London and New York the cost of money for most borrowers actually went up.

"Fed cuts fail to lower 30-year mortgage rates," notes the Los Angeles Times. At the long end of the yield curve, rates are determined more by fear of inflation than by the Fed’s price fixing. Thirty-year fixed-rate mortgages have gone up from 5.6% to 6.4%.

But even at the short end, where the Fed is pressing its fat thumb on the scale, "Money market rates rise as banks hoard cash," says a Bloomberg report.

The banks are holding onto their money because they figure they might need it. That’s what everyone does in the opening stages of a credit contraction. They’re afraid that if they lend it out…they will later discover that the borrower can’t pay it back.

Yesterday brought news that two big borrowers had gotten whacked. Endeavor Capital lost 28% trading Japanese bonds. And poor John Merriwether! Almost exactly 10 years ago, the man’s Long-Term Capital Management went broke. Now, the news tells us that his bond fund has just taken a 24% hit.

And Britain’s biggest mortgage lender – HBOS – denied rumors that it is having liquidity problems.

The Fed giveth.

Mr. Market taketh away.

It’s "the Great Unwind," says Citigroup. What is being unwound is the ball of debt, derivatives, speculation and outsized asset values all over the world.

The Dow fell yesterday – down 293 points. Commodities got whacked hard too. Oil lost nearly $4 a barrel. Gold dropped to $945. And copper – which tends to be an indicator for the whole economy – seems to have topped out.

In terms of our ‘battle’ between inflation and deflation, yesterday, deflation won.

*** In spite of all the bad news, Hell Week hasn’t really been so bad. It’s more like Purgatory or Limbo…or a halfway house after coming out of state prison.

The headlines speak of a worldwide financial crisis, but so far, the effects of this crisis are extremely limited. The OECD reports that unemployment around the globe is only 0.3% higher than it was a year ago, the same figure U.S. unemployment has risen during that period.

Aside from panicky capital markets, some areas don’t seem to be suffering at all. Latin America, Asia, the Gulf, and Africa all seem to be growing, with no significant economic effects – at least, not yet.

The Financial Times summarizes the outlook for the world’s major regions:

In the United States, people wonder how hard the landing will be.

In Europe and Japan they wonder whether the landing will be hard or soft.

In the rest of the world, they ask whether they will have a landing at all.

America’s central bank is now lending money at about half the rate of consumer price inflation. A borrower can take the money and almost certainly make money. If nothing changes, he’ll pay back money worth less than the money he borrowed…or, he can put it on deposit in Britain at twice the yield…or in Brazil, where he’ll get 5 times the yield.

The lower rate is intended to encourage borrowing. Whether it also encourages consumer spending, hiring, and capital investment is another whole group of questions with very uncertain answers. If the answer is yes…you can reasonably expect further inflation in the commodities markets…rising stock prices…and a positive GDP growth. If the answer is no…you can expect higher unemployment, falling stock and housing prices…and probably falling commodity prices too.

While yesterday was clearly a ‘no’ kind of day…there is no guarantee that every day will be a ‘no’ day.

Another way to look at this is a way long time Daily Reckoning sufferers will recognize: it is our familiar battle scene…with the heavy cavalry of inflation charging the steadfast infantry of deflation.

While that picture has fairly well described the financial world for the last year or so…we think it is time to add a complicating feature. It is as if a third army has appeared on the field of battle…of unknown size…and unknown intentions. So let us review the battle lines.

On the one side, is the familiar force of a credit cycle downturn…believed, by us, to be the beginning of a major contraction in the credit market. These things are big. The last big force in the credit world was the expansion that began in 1980. Obviously, it lasted for 25 years, perhaps a bit more. That expansion seems to have come to an end. Yields are about as low now as they were when the last expansion began…and probably turning up.

That "probably" is an important word. Recently, yields have been going down, as investors sought safety from default over safety from inflation. Looking for protection in the treasury market seems to us a bit like looking for veracity in the U.S. Congress…and we suspect that when things settle down, investors will realize they’ve made a mistake.

"The credit crunch is rapidly morphing into a credit collapse," says Harvard’s Kenneth Rogoff. "The same factors that propelled the housing bubble are now spinning in reverse. And there’s no bottom in sight."

On the other side, of course, is the other familiar force – inflation. It’s what you get when you favor the production of ‘money’ over the production of the things it is used to buy. Inflation is clearly driving up some prices. Oil is holding over $100. Gold has been on a tear for 8 years. Rice just hit a 32-year high. CNNMoney reports that inflation is Americans’ number one concern.

Meanwhile, keeping our pict-o-rama of the world’s financial scene before us, with inflation on the left, deflation on the right, down the center comes a huge, disorganized, polyglot collection of fighters – lean and hungry – emerging markets, oil producers, former Soviet republics…the bric-a-brac of humanity.

While deflation knocks down commodity prices – these emerging economies are buying them as fast as they can.

While inflation is pushing up automobile prices – they’re making new cars for only $2,500.

While deflation cools the U.S. economy – these third world economies are still heating up.

While inflation squeezes aging, middle class families in the West – in the East, millions of young, new families are becoming middle class, bursting at the seams with new consumer demand.

What will happen when these three armies collide?

We don’t know…but we’re watching…

*** Mentioning 1998 brings back memories. That was when people still believed the promise of the dotcom era. They thought new technology and capitalism would make them all rich. They ran up prices on Wall Street in anticipation.

And then we came up with a hypothesis: that when the tech bubble burst, the U.S. economy would sink into a long, slow Japan-like slump. With Addison, we wrote a book on the subject – Financial Reckoning Day – arguing that central bank wizardry might be able to stop inflation, but it had never proven that it could cure a deflationary slump. Even a bad central banker can stop inflation, if he has the backbone for it. The reason for this is almost too obvious; central banks can stop inflation because they are the ones who create it.

But deflation is the markets’ revenge…and central bankers have never shown they can stop it once it gets going. That is what we learned from the Japanese in the ’90s. You can use all the fiscal stimulus you want…and all the monetary stimulus too. It doesn’t mean the economy is going to pick up.

We’re beginning to think we were right in Financial Reckoning Day. Or almost right. Yes, dear reader, we said that after the tech bubble popped, the U.S. economy would enter a long, slow slump, a al Japan. Obviously, we were too early…there was one more big bubble still to go – in residential property. But now that that bubble has come and gone, here we are again – possibly facing another Japan-style funk.

*** "It’s no secret: Homebuilding stocks have performed horribly," says our colleague Dan Amoss. "Most are 60% or 70% below their highs. A few regional builders are in the low single digits, drowning in debt and heading to zero."

"But stocks never move in a straight line. The sector has enjoyed a massive short covering rally since late January. Most are up 40% or more in a few weeks. This gives us a good short selling opportunity.

"Homebuilding bulls are hoping for a quick housing market recovery, because they need one for the stocks to have a sustainable rally. This spring, as selling season kicks off, you’ll start hearing ‘affordability’ arguments from housing bulls in the media. I suggest ignoring them.

"Housing bulls fail to appreciate how the easiest mortgage environment in history magnified every homebuyer’s purchasing power. They also focus on monthly payments in a 5-6% mortgage environment, without incorporating the burden of falling house prices. Incomes and 5% mortgages can support housing prices in many areas of the U.S., but not in areas like Las Vegas, Phoenix, and most of California and Florida.

"Measured over a full boom-and-bust cycle, homebuilding is not a great business. Even at the peak of the housing bubble, most builders’ operating profit margins maxed out at 15%. This business is capital-intensive and requires a rising house price environment to thrive. The most aggressive homebuilders loaded up on raw land at inflated prices and levered their balance sheets with visible and hidden debt. Now most are liquidating inventory as fast as possible, even at steep losses.

*** What are they putting in the water in New York? Has no one any sense or dignity?

First, Eliot Spitzer confesses to a mortal sin and resigns his post as governor of the state. Then, his replacement goes before the cameras to make a similar admission – even before he’s accused of anything.

Then, it gets even tawdrier. His wife, for no apparent reason other than to frolic in the sewer with the two governors, revealed that she too had done things that would make her eligible for death by lapidation in other countries. But this is New York, remember. She’ll probably go on Oprah instead.

And, as if all this weren’t absurd and pathetic enough, we discover that New York’s new governor and his wife went to the Days Inn on upper Broadway and 94th Street in order to bring more excitement to their married life. The Days Inn?

At this point, your editor notices his stomach seizing up…and beginning to convulse. He doesn’t know whether he is going to laugh, or be sick.